It is hard to imagine a more conflicting situation. Inflation is the hot topic on countless television and radio debate shows, and potential buyers are queuing up outside precious metal shops. On the major bond markets, on the other hand, yields seem to be falling into an abyss, as if inflation had been nailed into its coffin for the foreseeable future. Yields on German government bonds touched all-time lows in late May, with US long-term interest rates also hovering at an exceptionally low level. The abundant supply of government bonds has failed to depress prices and raise interest rates.

, Jun 21, 2010

So does this debunk the theory that prices depend on supply and demand and will we have to follow in the footsteps of the Japanese and resign ourselves to extremely low interest rates for the long term? It is in our view important that we remain cautious in dismissing basic economic theories and explanations. The emergence of truly new structures is less common than is sometimes claimed. Let's not forget, by way of example, that little more than a decade ago, the New Economy hype sent shares skyrocketing to unprecedented heights, taking price-to-earnings ratios along with them. Today, we know that this was nothing more than a bubble.

Our view is that a well-grounded economic analysis is the only way to assess the developments on the bond markets. The aim should be to weigh up the likelihood of a range of economic scenarios, wherever possible based on quantitative models. Below, we have provided a brief sketch of this approach.